Debunking Economics Part 2: Efficiency and Equilibrium

You or I have an idea about what the word efficiency means, but what does it mean to an economist? Steve Keen, whose book Debunking Economics I’m exploring in these posts, explains:

“Many sciences harness words which are in common usage, but give them quite a different technical meaning. But no other science plays so fast and loose with the English language as economics… when economists say that markets are efficient they mean that they believe that stock markets accurately predict price stocks on the basis of their unknown future earnings.”

The phras in bold goes by the name of the efficient market hypothesis a.k.a. “you can’t beat the market”. Like the theory that “there is no such thing as society” its proof would help silence critics of the notion that markets are “the best of all possible worlds”. Also like that previous theory, the assumptions we need to put in to get the proof out are so patently ridiculous that it simply cannot describe the real world. Real markets are not “efficient”, at least not in the economists’ sense of the word.

Steve Keen. His t-shirt says: “The difficulty lies, not in the new ideas, but in escaping from the old ones” — J.M.Keynes

Prof. Keen goes on:

“to ‘prove’ that markets are efficient in this sense, economists need to make three bizarre assumptions:

– That all investors have identical expectations about the future prospects of all companies

– That all these identical expectations are correct

– That all investors have equal access to unlimited credit

Clearly these assumptions would only hold if each and every stock market investor were God.”

William.F. Sharpe, a bank of Sweden prize winning economist (1990) who worked upon “proving” the market efficiency hypothesis, comments on these hypotheses that:

“Needless to say these are highly restrictive and unrealistic assumptions. However, since the proper test of a theory is not the realism of its assumptions but the acceptability of its implications [more later!], and since these assumptions imply equilibrium conditions which form a major part of classical financial doctrine, it is far from clear that this formulation should be rejected – especially in view of the dearth of alternative models leading to similar results.”

Incredible! This is not how science works – you do not decide in advance what you wish to prove – independent of reality – then fudge whatever assumptions are necessary to get there! Sharpe even uses the word doctrine to describe this methodology. Does economics aim to be a social science or a body of dogma?!

William F. Sharpe

What does efficiency (meaning perfect pricing) imply? In an efficient market, so the theory goes, an individual investor will first seek to reach equilibrium – equalising the supply and demand of whatever good they are trading to obtain via the market (remember, our omnipotent investor is assumed to know the current and future state of  supply and demand for every good perfectly, and match their investment decisions accordingly). Then, apparently, the combined effect of every such individual  investor reaching equilibrium will translate into the equilibrium of the system as a whole – general equilibrium.

These assumptions about omnipotent investor behaviour – everybody knows everything and is maximally enabled to act upon it – are made for similar reasons to the those about consumer behaviour in my previous post. To go from individual behaviour to that of the whole market involves a complicated system of feedbacks, described by non-linear equations. This is what economists wish to avoid, by fudging their assumptions to obtain a simple system of linear equations describing a market in general equilibrium.

Gerard Debreau’s book – the cover should read “Winner of The Sveriges Riksbank Prize in Memory of Alfred Nobel”

Such fudges are often hilarious. Take the following assumption about certainty, from Bank of Sweden prize winning economist Gerard Debreau’s book “Theory of Value”:

“The certainty assumption implies that he knows now what input-output combinations will be possible in the future (although he may not know the details of technical processes which will make them possible)…”

The relevant technology may not even have been invented yet! Nevertheless “he knows now what input-output combinations will be possible in the future“! How exactly? Does the above investor practice divination, by reading sheep entrails perhaps?! On the basis of this assumed perfect information, Debreau’s hypothesized market participants then go on to make plans. In his words:

“As in the case of a producer, the role of a consumer is to choose a complete consumption plan … His role is to choose (and carry out) a consumption plan made now and for the whole future i.e. a specification of the quantities of all his inputs and all his outputs.”

Markets are always in equilibrium then, because at any one instant plans are declared to be made “now and for the whole future”. Keynes’ well known expression “in the long run we are all dead” , taken in context, was a criticism of this absurd notion that markets live in a placid state of equilibrium rather than a volatile state of dis-equilibrium:

“But this long run is a misleading guide to current affairs. In the long run we are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past the ocean is flat again.”

In other words, “Equilibrium is blither”, as Keynes also said.

Economists then, fudge their assumptions to ensure that the markets of their models are always in equilibrium, whereas real markets are never in equilibrium. The reasons for this fudge are ideological – Prof. Keen has this to say about it:

“Today, most economists imperiously dismiss the notion that ideology plays any part in their thinking. The profession has in fact devised the term ‘positive economics’ to signify economic theory without any value judgements, while describing economics with value judgements as ‘normative economics’ – and the positive is exalted far above the normative.

Yet ideology innately lurks within ‘positive economics’ in the form of the core belief in equilibrium. As previous chapters have shown, economic theory has contorted itself to ensure that it reaches the conclusion that a market economy will achieve equilibrium. The defence of this core belief is what made economics so resistant to change, since virtually every challenge to economic theory has called upon it to abandon the concept of equilibrium. It has refused to do so and thus each challenge – Sraffa’s critique, the calamity of the great depression,  Keynes’ challenge, the modern science of complexity – has been repulsed, ignored or belittled.”

Hopefully I have convinced you that there is no such thing as ‘positive economics’ – bizarre assumptions made to obtain the desired doctrine are merely disguised by mathematical formalism, hence made implicit rather than explicit.

Milton Friedman, also a bank-of-Sweden-prize-winner (in 1976)

Economists also like to argue that the realism of their assumption doesn’t matter – recall W.F.Sharpe’s earlier assertion that “the proper test of a theory is not the realism of its assumptions but the acceptability of its implications“. Milton Friedman put it so:

“in general, the more significant the theory the more unrealistic the assumptions. The reason is simple. A hypothesis is important if it “explains” much by little, that is, if it abstracts the common and crucial elements from the mass of complex and detailed circumstances surrounding the phenomena to be explained …

To put this point less paradoxically, the relevant question to ask about the “assumptions” of a theory is not whether they are descriptively realistic, which they never are, but whether they are sufficiently good approximations for the purpose in hand . And this question can be answered only by seeing whether the theory works , which means whether it yields sufficiently accurate predictions.”

The first rejoinder to the above argument is obvious: the models of economists don’t yield sufficiently accurate predictions, so they fail on Friedman’s own terms. This is why the Queen of England could ask at a meeting with “leading” economists after the financial crisis “Why didn’t you see this coming?” and most could only respond by looking sheepish. And this is to say nothing of the outcome of the neo-liberal “experiments” in “laboratories” like Latin America.

The second rejoinder is a little less obvious but equally devastating to Friedman’s argument. There is a difference between abstracting away irrelevant details (e.g. “let us model the cow as a sphere”) and assuming properties in direct contradiction with actual behavior (e.g. “let us model the cow as a lion”)  This is not a simplifying assumption but a wrong assumption! It is not “abstracting the common and crucial elements” of a cow to call it a lion!

Prof. Keen categorises the former (“spherical-cows”) as a negligibility assumption and the latter (“lion-cows”) as a domain assumption, referencing the work of  the philosopher Alan Musgrave (whose PhD was supervised by the famous philosopher of science Karl Popper). If many of the erroneous assumptions economists make are domain assumptions (“lion-cows”), which they are, Friedman’s argument collapses. Thinking about it, it would almost be a miracle if a model based upon people and markets behaving in ways directly contrary to reality (and often actually impossible!) made accurate predictions about reality.

Proper scientists seek to not throw out the baby (a description of objective reality) with the bathwater (the outcome of the simplifying assumptions going into their models). It seems economists would rather throw out the baby, to preserve their bathwater – the market efficiency hypothesis and general equilibrium. A more reasonable alternative methodology is outlined by Prof Keen at the end of his chapter about equilibrium:

“economists have conflated the concept of equilibrium with the vision of an ‘economic utopia’ in which no-one could be made better off without making someone else worse off. But a free market economy could never remain in an optimal position because economic equilibria are unstable. The real question us whether we can control such as unstable system – whether we can constrain its instability within acceptable bounds.”

I myself remain unconvinced that the answer to Prof Keen’s “real question” is affirmative. Having said that, since we are stuck with market systems for the time being, I agree that it would be far better to constrain them than to let them run amok. Both economic theory itself (when interpreted properly) and actual experience show no reason to expect desirable social outcomes to come from deregulated markets.

Click here to read part 3!

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~ by freedomthistime on December 22, 2011.

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